NEW YORK, June 13 (Reuters) - The dollar dropped to a three-week low on Tuesday on news of the smallest annual increase in inflation last month in more than two years, cementing expectations that the Federal Reserve will pause interest rate hikes at its two-day meeting ending on Wednesday.
The dollar index slid as low as 103.04 following the data, and was last down 0.3% at 103.29 . The euro rose 0.3% to $1.0793 after climbing to $1.0824, its highest since May 22.
Against the yen, the dollar rose 0.4% to 140.17 yen .
Tuesday's data showed the U.S. consumer price index (CPI) edged up 0.1% last month after increasing 0.4% in April. In the 12 months to May, the CPI climbed 4.0%, the smallest year-on-year increase since March 2021, after rising 4.9% in April.
So-called core CPI gained 0.4% in May, the same percentage rise for the third straight month.
John Madziyire, senior portfolio manager at Vanguard, said in the wake of the CPI data, his firm has "high conviction" that the Fed is going to pause on Wednesday.
"Clearly before this meeting, there is evidence that the Fed has tightened quite a bit. Before the bank crunch, the question was maybe we now have a higher terminal rate, or some sort of no-landing, or the hikes are not being felt, and we may have to go significantly further," said Madziyire, referring to this year's collapse of Silicon Valley Bank, Signature Bank and First Republic Bank.
"But the fact that banks experienced some turmoil or mini-crisis tells us that we're getting to the point where there is an impact from all these hikes. From the Fed's perspective, they want to give themselves some time to assess, so that's why it's probably a skip, with some data dependency."
Traders of futures tied to the Fed's policy rate now expect a roughly 93% chance the U.S. central bank will decide to forgo an 11th straight interest-rate hike and keep the benchmark rate at 5.00% to 5.25% on Wednesday . Before the report, traders saw a 75% chance of a June rate increase.
The rate futures market, however, trimmed bets on a Fed hike in July to a 64% probability, down from more than 70% late Monday.
The European Central Bank's rate decision is up next on Thursday, with markets pricing in a 25 basis-point hike and another in July before a pause for the rest of the year.
The Bank of Japan, due to announce a monetary policy decision on Friday, is expected to maintain its ultra-dovish stance and yield curve control settings.
Elsewhere, sterling jumped after employment data came in much stronger than expected, with wages rising sharply, adding to inflation concerns.
The pound hit a five-week high of $1.2625 against the dollar and was last up 0.8% at $1.2609, as traders bet the Bank of England would have to raise rates further than previously expected.
In Asia, China's yuan fell to a six-month low after the central bank lowered a short-term lending rate for the first time in 10 months, in a bid to restore market confidence.
The onshore yuan bottomed at 7.168 per dollar, its lowest since November, and last traded at 7.158, down 0.2%.
Its offshore counterpart CNH=D3 weakened to a new six-month low of 7.178, before paring losses slightly.
Currency bid prices at 4:16PM (2016 GMT)
Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Harry Robertson in London and Rae Wee in Singapore; Editing by Kirsten Donovan and Richard Chang
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